Understanding the Boom Phase in an Economic Bubble

Understanding the Boom Phase in an Economic Bubble

An economic bubble refers to a situation where the price for an asset exceeds its fundamental value by a significant margin. These misaligned prices reflect more speculative demand than intrinsic worth, leading to a rapid increase in asset values, followed by a sudden decrease, commonly known as a "burst." The process of a bubble is complex and involves several stages, which we will explore in detail.

Hyman P. Minsky's Theory of Financial Instability

One prominent economist who contributed to our understanding of financial bubbles is Hyman P. Minsky. He developed a theory explaining the development of financial instability and outlined five stages of a typical credit cycle: displacement, boom, euphoria, profit-taking, and panic. These stages describe how market conditions and investor sentiment evolve throughout a bubble's life cycle.

Stage 1: Displacement

A bubble begins when investors become captivated by a new idea or innovation, such as a technological breakthrough or low interest rates. This initial stage sets the groundwork for the subsequent phases of the bubble.

Stage 2: Boom

In the boom phase, asset prices start to rise gradually due to increased investment based on the new paradigm. As more and more individuals join the market, the asset gains momentum, attracting widespread media attention and sparking fear of missing out on potential future opportunities. This build-up paves the way for the next phase.

Stage 3: Euphoria

During the euphoric phase, caution is discarded as asset prices soar, with the 'greater fool' theory coming into play wherever asset prices skyrocket. Valuations reach extreme levels, and new measures are introduced to justify the inflating asset prices.

Stage 4: Profit-Taking

As the bubble grows larger, investors begin to consider selling their holdings, anticipating a potential correction. This leads to a certain level of panic and uncertainty, prompting some to take profits.

Stage 5: Panic

Eventually, the bubble bursts when the unsustainable asset prices collapse, triggering a mass sell-off among investors. Market volatility intensifies quickly, and asset prices plummet.

Although bubbles are challenging to predict, recognizing these five stages can potentially help us understand why asset prices behave in such a manner. Additionally, studying past bubbles offers valuable insights into the dynamics of these phenomena, allowing us to perhaps better handle future instances.